Dear Dr. Don,
If I have saved money and invested it in bonds and fixed accounts, will I be as well off in retirement as people who have retirement plans from a company (in particular, hospitals)? I mean, money is money when you use those retirement calculators, isn’t it?
— Awana Retire
First, let’s make the distinction between a defined benefit plan (like a pension plan) and a defined contribution plan, such as 401(k), Roth 401(k), 403(b) and Roth 403(b) plans with an employer. I’m going to assume you aren’t talking about a pension plan and that you are curious about how your taxable investments compare with an employer’s tax-advantaged retirement account.
One big advantage of a company plan occurs if the company matches all or part of the employee’s contribution to the plan. A common provision would be for the employer to contribute 50 percent of an employee’s contributions up to 6 percent of salary. That means that if you contribute 6 percent of salary to the retirement account, the employer contributes 3 percent of salary. A 50 percent return on investment is an attractive incentive to participate in a firm’s plan.
Many hospitals are nonprofits and as such will have a 403(b) plan versus a 401(k) plan. These numbers and letters just refer to the specific part of the Internal Revenue Code that defines these plans, and 403(b) plans are for nonprofit institutions. It’s not as common for 403(b) plans to have contribution matches.
Another advantage of a 401(k) or 401(b) plan is that you are contributing pretax dollars. That makes it easier to find room in your budget to fund plan contributions. The downside is that distributions out of the accounts are taxed at ordinary income rates. This rate may be substantially higher than the capital gains rate on a long-term investment.
Roth 401(b) and Roth 403(b) plans are relative newcomers to employer-sponsored retirement plans. In these accounts, contributions are made with after-tax dollars, but qualified distributions in retirement are free of federal income taxes. Employer matching contributions are considered to be made with pretax dollars and are typically held in a traditional 401(k) or 403(b) account. That means qualified distributions of employer matching funds are taxed at ordinary income rates.
An advantage of having your money invested in taxable accounts is that by managing your investment portfolio, you can have more control over the impact of taxes on your portfolio. In general, you recognize income in the year it is earned, but a capital gain or loss isn’t recognized until it is realized by the sale of the investment.
Using a retirement calculator to estimate what you need to save in a taxable account isn’t particularly realistic because it doesn’t properly consider the tax impact of your investments.
An investment calculator, like Bankrate’s “Return on investment calculator,” is a better choice to see how your retirement nest egg will grow in a taxable account.
I hope you’ve learned from this discussion that you need to at least consider the choices in tax-advantaged retirement plans offered by your employer. It’s not certain that you’d be better off by contributing to the employer-sponsored plan. However, it wouldn’t take much — like a matching program — to nudge the decision in that direction.
My best advice is to meet with your tax professional or a fee-based financial planner to discuss your current investment strategy and whether you could improve upon it by adding contributions to your employer’s plan.